Fiscal restraint is key – stimulus in the current environment will trigger rate hikes

Fiscal policy has entered a period of normalization, with the priority turning to ensuring a consistent policy mix to deliver price and financial stability and reduce debt vulnerabilities. Fiscal deficits and public debt ratios have fallen since 2020, and inflation surprises have helped the adjustment of public balance sheets in some countries. But relying on inflation to keep reducing debt is not a sustainable approach, as bondholders would demand higher interest rates to compensate for higher and more volatile inflation. Moreover, deficits and debts generally remain above prepandemic levels, which means that additional fiscal efforts will be needed in the years ahead. In the present environment of high inflation, rising interest rates, and elevated debt, it is critical that fiscal and monetary policies are aligned to ensure price and financial stability. In many countries, fiscal policy should tighten to help ease inflation pressures, thereby allowing central banks to raise interest rates by less than otherwise (see Chapter 2). Such fiscal restraint should protect priority areas and manage heightened social demands from the cost-of-living crisis amid a slowdown in economic growth. Even so, spending pressures will need to be contained, as different groups may seek to be compensated for past inflation. Full compensation could make inflation more persistent and require additional monetary and fiscal tightening in the future. An overall fiscal tightening that protects the vulnerable through targeted measures can help countries achieve an appropriate policy mix (see Chapter 2).